European Divergence Case Study

The European Divergence Scenario illustrates the Adaptive Stress Testing frame­work well. With the introduction of the Euro, credit spreads converged for all member countries and started an unsustainable cycle of credit growth in high inflation countries like Greece, Italy, Portugal, and Spain. The artificial stability of the Euro currency was a classic Minsky case of stability breeding instability. As hidden imbalances continued to build up in the Euro periphery, Innovators like GaveKal Research analyzed the unsustainability of “PIGS” borrowing levels, and launched a European Divergence Fund in November 2007:

For ten years, investors have made money on convergence trades (i. e., Italian rates falling to meet German rates).These convergence trades were always based on politics, not economics. However, in the long-run, economics always wins out. And now, as credit conditions tighten around the world, should be the time when this happens.—Louis-Vincent Gave, GaveKal Funds Newsletter, November 11th, 2007